Up and Down and Up and...

The Roller Coaster Continues...

I sit to write this missive and start typing the same thing I typed last time. What more is there to say? The economy is most clearly going backwards; the bond market is behaving entirely irrationally; stocks keep getting cheaper. What's an investment manager to do? I'll take the easy route and just answer the two questions that we get from clients, friends and the Friday morning Rotary meeting...

1. Where is the bottom? You already know my answer: I don't know. But what I do know is to look at past cycles and examine what was going on and how the market bottomed. In my analytical world, the "price" of stocks isn't the number you see on the front page of Yahoo -- it's an inflation-adjusted price-earnings ratio that looks at the last 10 years of earnings. My PE ratio tells me how much I am paying -- the price -- for the expected earnings of stocks over some reasonably long future period. That, and that alone, is the price that we care about when parsing historic tables and making judgments about stocks.

Using our methodology, stocks have bottomed with a PE of 7-8 several times in the past 75 years. They closed today at a PE of about 13. That means that the S&P 500 *could* fall another 45%. Yikes. That would be a 70% decline from its peak in summer 2007. A huge fall, to be sure, but not unprecedented.

However, as my friend and friendly competitor Eric Hull pointed out to me recently, those single-digit PE bottoms have generally occurred in a period of accelerating, double-digit inflation. The market bottoms in periods of declining and low inflation have been in the 11 to 13 range. When we came to work this morning, the PE was at 12.5 and we bought some stocks. Not a lot -- just 2-5% in most accounts.

I will not make any prediction about a possible market bottom, but I can tell you this with all candor: History shows that investors who buy stocks at prices like we see today are amply rewarded over 5-7 year periods. Patience is the key -- if you have the stomach for some volatility, the odds are very high that the total return on stocks over the next 5-7 years will be higher than the returns to bonds or cash, especially after adjusting for inflation.

2. What Kind of Stocks Should I Buy? For the first time in 50 years, the dividend yield on a basket of blue-chip stocks is significantly higher than the yield on long-term treasurys. The 10-year treasury closed today yielding 3.17%, and the yield on our favorite bundle of dividend stocks is over 5.5%. Even better, yields on stocks rise with inflation over time, while yields on bonds are fixed.

This situation might not strike you as all that earth-shattering, but I assure you it is. This is a major milestone that I never thought I would see in my lifetime. For my entire career, the choice about stocks came down to something like this: I can buy stocks and earn a nothing yield of 2% and hope stocks go up. Or, I can put money in cash and bonds and earn 5-6%. But I will miss out on any stock upside.

Today, we can own stocks and earn much higher income than on cash and bonds, and we still have all the upside of stocks. Keep in mind that, if we buy $100k of stocks and receive a $5k annual dividend, we keep getting that $5k even if the stocks go down. That $5k is higher than the $1k to $3k we would have gotten from cash or bonds. From an income perspective, we are no worse off by owning stocks -- even if they go down in the near term. If you have the willpower to stay with that decision for 5-7 years, I am highly confident you will be happy you did.

Our recommendation, should you choose to buy stocks right now, is to look at dividend-oriented stock mutual funds and ETFs. The usual search tools at Morningstar and Schwab can point you in the right direction.

Have a wonderful Thanksgiving week!

Cheers,
Rick Ashburn